Recklessness Does Not Amount to Willfully Understating Tax By a Preparer

In the case of Rodgers v. United States, 123 AFTR 2d 2019-2294[1], the Ninth Circuit Court of Appeals agreed that the District Court had applied the wrong standard in determining if a preparer penalty applied.  But, as will become clear, that doesn’t mean the preparer will fare any better when the case goes back to the District Court to have the proper standard applied.

The case involved $45,000 of penalties imposed against a CPA/attorney for preparation of returns for five taxpayers under IRC §6694(b).[2]

IRC §6694(b)(2) provides:

(b) Understatement due to willful or reckless conduct

(1) In general

Any tax return preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to a conduct described in paragraph (2) shall pay a penalty with respect to each such return or claim in an amount equal to the greater of—

(A) $5,000, or

(B) 75 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

(2) Willful or reckless conduct

Conduct described in this paragraph is conduct by the tax return preparer which is—

(A) a willful attempt in any manner to understate the liability for tax on the return or claim, or

(B) a reckless or intentional disregard of rules or regulations.

(3) Reduction in penalty

The amount of any penalty payable by any person by reason of this subsection for any return or claim for refund shall be reduced by the amount of the penalty paid by such person by reason of subsection (a).

For four of the returns, the District Court determined that the preparer had engaged in willful conduct under IRC §6694(b)(2)(A) as the justification for imposing the penalty.  The District Court had concluded that the preparer had engaged in reckless conduct which was a willful violation.

The Ninth Circuit panel, in an unpublished decision, agreed with the taxpayer that reckless conduct does not, by itself, establish willfulness for purposes of IRC §6694(b)(2)(A).  The panel explained:

As we explained in Richey v. IRS, 9 F.3d 1407, 1411 (9th Cir. 1993), willfulness under § 6694(b)(2)(A) requires “a conscious act or omission made in the knowledge that a duty is therefore not being met.” Id. (quoting Pickering v. United States 691 F.2d 853, 855 [50 AFTR 2d 82-6045] (8th Cir. 1982)). We further noted that the definition of “willful” in § 6694(b) is the “same” as the definition used in 26 U.S.C. § 7206. Id. As the Supreme Court has explained, that definition does not include recklessness. See United States v. Bishop, 412 U.S. 346, 354 (1973).[3]

However, the District Court’s finding that, for two other returns, the preparer had engaged in a reckless or intentional disregard of the rules under IRC §6694(b)(2)(B) was sustained by the panel.

The district court found that Rodgers knew the applicable rules; had all the information necessary to evaluate and apply the rules; but, ultimately, failed to apply the rules, resulting in an understatement on the Keller and Ross returns. The district court also considered Rodgers’ explanation for failing to apply the rules—that he did so inadvertently— and rejected it as not credible. The district court’s conclusion that Rodgers recklessly or intentionally disregarded tax rules or regulations was based on an application of the correct statutory standard, and was not clearly erroneous.[4]

Thus, the penalties for these returns were sustained.

For the four returns where the District Court had found willfulness, the panel remanded the case back to the District Court to determine if the penalties were justified once the proper standard is applied.  So, it’s possible that either the trial court would now determine that such a conscious act to avoid a known duty had existed, or that the recklessness included disregarding tax rules, getting back to the same penalty.

So, what had happened that caused the District Court to find for penalties to being with?  Well, the original 2017 District Court opinion gives a laundry list of problems with the preparation of the returns in question.

The District Court opinion noted that the preparer’s firm had been engaged to prepare two individual returns (Ross and Keller), two corporate returns for corporations that these individuals owned 100% of (Rossmith and Ross Pac), and an additional corporate return for a corporation the two individuals owned two thirds of (Freshtech).[5]

There was also a rental condominium that entered into the situation.  As the District Court opinion described:

31. During 2009 and 2010, Keller owned a condominium in West Hollywood, California, referred to as the Kings Road Condo. Keller Dep. (Dkt. 42), 102:9-106-6.

32. Keller planned to use the Kings Road Condo for his business travel to the west coast. Keller Dep. (Dkt. 42), 102:9-106:6.

33. Keller told Rodgers of his plan for the Kings Road Condo in 2008 and provided to Rodgers a lease agreement dated March 2008 between himself and Rossmith regarding the Kings Road Condo. Exhibit 15; Rodgers Decl. (Dkt. 60), ¶¶ 60, 61; Keller Dep. (Dkt. 42), 102:9-106:6.

34. Keller changed his mind, however, and rented out the Kings Road Condo to an unrelated person. The Kings Road Condo was never used for business purposes. Keller Dep. (Dkt. 42), 102:9-106:6.

35. Although Keller never used the Kings Road Condo for business, Rossmith paid various expenses associated with the Kings Road condominium in 2009. Specifically, in 2009 Rossmith paid a total of $50,565.98 for expenses associated with Keller's Kings Road Condo. Rossmith was reimbursed $1,831.35 by Freshtech and $19,582.96 by Ross Pac for those expenses. Keller Dep. (Dkt. 42), 103:24-25); Ex.126 at US001209.

36. Rossmith also paid various expenses associated with the Kings Road Condo in 2010. Specifically, in 2010 Rossmith paid a total of $55,013.08 toward Keller's Kings Road Condo. Rossmith was reimbursed $28,656.41 by Freshtech and $26,040.04 by Ross Pac for those expenses. Keller Dep. (Dkt. 42), 103:24-25; Ex. 127 at US001452-1453.

37. In addition, in 2009, Rossmith paid to Keller or on behalf of Keller, property taxes for the Kings Road Condo of $7,942.52. Styck Decl. (Dkt. 56), ¶ 20; Ex. 126 at US001197.

38. In addition, in 2010, Rossmith paid to Keller or on behalf of Keller, property taxes for the Kings Road Condo of at least $3,508.40. Styck Decl. (Dkt. 56), ¶ 20; Ex. 127 at US001441-42.

The bookkeeper for Rossmith maintained a suspense account which, as the Court noted, generally was used for items that she was unsure of proper treatment of.  The non-CPA, non-attorney preparer that was preparing Rossmith’s return directed the bookkeeper to rename the account “corporate-operating expenses.”[6]

The preparer who was assigned these returns viewed the preparation of these returns as “very complex” and that she had “never before seen returns” like those for these taxpayers.[7]

No one in the firm looked at the actual general ledgers of the taxpayers, nor did they request copies of such ledgers.  Rodgers stated he had chosen not to look at the ledgers because looking at the ledgers was “not cost effective.”  The $6,700 he had charged to prepare the entire set of returns did not justify looking at the ledgers “unless there’s a reason.”)[8]

However, issues were noted when reviewing the profit and loss statements provided to the firm.  Various accounts in the profit and loss statement had negative account balances, which indicated to Rodgers that items were not properly characterized on the books.  All in all, the profit and loss statements went through four separate iterations before the returns were prepared based on these issues that were found when the firm looked at the submitted profit and loss statements.  However, the firm never asked for supporting documentation.[9]

One particular entry in the ledger is noted in the District Court case--$212,000 was paid from Ross Pac to Rossmith.  Rossmith entered the $212,000 receipt as a credit to “corporate operating expense” while Ross Pac kept it in suspense.  At the direction of the firm that prepared the return, Ross Pac reclassified this amount of cost of goods sold even though there was no purchase of goods from Rossmith.[10]

As well, in preparing Ross’ individual income tax returns, the firm did not apply the limits on deductible home mortgage interest under IRC §163(h)(3).  The interest claimed was in excess of those limits, understating the tax.  Rodgers was aware of the mortgage interest limitation rules.[11]

Issues also arose with regard to the home office expense deduction claimed.  Ross had an office in his home of about 650 square feet of his 4,000 square-foot home.  Rodgers, the CPA/attorney in charge of the return, was aware of the home office but didn’t believe obtaining that information, believing his office knew the number.  However, that did not turn out to be the case, as the preparer claimed she was relying on Rodgers for the number.  Neither the taxpayer nor the bookkeeper recall being asked by anything at the firm about the relative square footage of the office.[12]

The opinion notes that whatever was done to determine a home office deduction amount, the actual amounts claimed were at least $21,000 overstated for one year and $3,800 for another—and that was assuming that even items like pool maintenance could somehow be determined to be allocable expenses.[13]

For the other individual (Keller), the firm failed to apply the passive activity loss limitations on his return.  Although Rodgers knew of the limitation, he did not apply it to Keller’s return despite the fact that it was applicable.[14]

Over $100,000 paid either to Keller or on his behalf by Rossmith was not reported as income on Keller’s return.  However, the firm did claim substantial expenses related to that rental.[15]

Rossmith’s books showed over $422,000 of payments received from Ross Pac and Freshtec that were not allocated to any expense. Such transfers above the allocated expenses were supposed to be treated as income by Rossmith, a fact that Rodger’s partner, the CPA who handled mainly accounting issues, was aware of.[16]  The District Court opinion continues:

Despite Barbieri’s knowledge that a negative balance in the corporate-operating expense category was income to Rossmith, it was not reported as income on Rossmith’s 2009 and 2010 returns. This is shown by the absence of the negative corporate-operating-expense account in the computation of the gross receipts reported on the tax return. Other than gross receipts, no other income items are reported on Rossmith’s 2009 return. Thus, Rossmith did not include as income the $422,959.27 in transfers from Ross Pac and Freshtech that exceeded their reimbursement payments for shared expenses. Absent any other adjustments, an understatement of total income by $422,959.27 yields an understatement of taxable income by that amount which yields an understatement of tax.[17]

The opinion noted a large discrepancy between salaries/consulting/1099 expense reported on the return vs. that reported on the ledger, with the return showing over $152,000 of such expenses beyond that reflected on the books of the company.[18]

The corporate return also claimed a deduction for taxes that included taxes related to Keller’s King Road condominium, expenses that Keller also had a deduction claimed for on his returns.  The taxes were overstated on the corporate return by nearly $88,700.[19]  The corporate return as well included a full deduction for country club dues, something for which no deduction is allowed per IRC §274(a)(3).[20]

And there are plenty more issues where these came from that impacted the other two corporations.

While the District Court was reversed for those returns on which it had found willful understatement, it is important to remember the Court concluded the preparer had acted recklessly with regard to all of the returns. 

How could this happen?  The Court was clearly troubled by the preparer’s unwillingness to dig deeper even though he knew that even without looking at the ledgers there were major problems with the trial balance information provided to the firm—errors that took four separate iterations to finally get a trial balance that didn’t have errors that were obvious from merely reading the trial balance.

The only real justification that the preparer gave was that it wasn’t efficient to dig that deep when his fee was only $6,700 for seven returns over two years.  Unfortunately, that’s not really a defense once a preparer has reason to believe the information provided was unreliable.  As well, the fact that the preparer didn’t catch cases where there were significant errors such as unreported income or double reported deductions did not help matters.

[1], retrieved July 9, 2019

[2] John Q. Rodgers v. United States, Case No. 2:15-cv-09441, US DC CD CA, November 8, 2017,

[3], retrieved July 9, 2019, p. 2

[4] Ibid, p. 3

[5] John Q. Rodgers v. United States, Case No. 2:15-cv-09441, US DC CD CA, November 8, 2017

[6] Ibid, paragraph 60

[7] Ibid, paragraph 67

[8] Ibid, paragraph 69

[9][9] Ibid, paragraphs 69, 70, 71, 72 and 73

[10] Ibid, paragraphs 74, 75

[11] Ibid, paragraphs 80, 81

[12] Ibid, paragraphs 82-85

[13] Ibid, paragraph 87

[14] Ibid, paragraphs 89-90

[15] Ibid, paragraphs 91-92

[16] Ibid, paragraphs 97-98

[17] Ibid, paragraph 99

[18] Ibid, paragraphs 100-101

[19] Ibid, paragraph 102

[20] Ibid, paragraph 105